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26. October 2020 | Overview of the OECD Model Agreement – OECD-MA as the basis for DTA

08. January 2021 | Double Taxation and Double Taxation Agreement (this contribution)

08. January 2021 | Overview of the most important articles of the OECD-MA

08. January 2021 | Double taxation without DTA: Business relations with countries without DTA

In international tax law, there can be double taxation of income in different countries due to several tax connecting points. Therefore, states conclude agreements with each other to avoid double taxation, so-called double taxation agreements (DTA). This is usually based on the OECD model agreement. What tax points are and what extent they have, you can find out in this article. In addition, you get an introduction to the law of double taxation on the one hand and an explanation of the effectiveness of DBAs on the other hand.

Double taxation (also called multiple taxation) arises when more than one state makes a claim for income or profits generated. This often happens when people or companies have several tax reference points and these are located in different countries. A tax reference point is to be understood very broadly here: residence, habitual residence, permanent establishment and other types of establishments all represent a separate reference point depending on the circumstances.

For tax purposes, however, only pure sources of income or mere domestic activities can be a starting point. For example, if you live in Paris and hold a share in a domestic GmbH, then the distributed dividend (profit distribution) also leads to a starting point in Germany, since this is the source state.

In international tax law, it is therefore important to know the terms about personal tax liability: unlimited and limited tax liability. The personal tax obligation describes who as a person has to pay taxes in Germany at all. Anyone who has a residence or habitual residence in Germany is subject to unlimited tax liability. However, anyone who has no domicile in Germany but still earns income (in the sense of § 49 EStG) from Germany is subject to the limited tax liability.

1.2.1. Country of residence principle and world income principle

The unlimited tax liability (by residence in Germany) also goes hand in hand with the so-called world income principle. Anyone who is taxed unrestrictedly must tax all income in Germany, no matter where it originated in the world or which state still has a tax right on it.

1.2.2. The source country principle and territoriality principle

In contrast to unlimited tax liability, limited tax liability is accompanied by the territorial principle. Only those incomes that have been created in Germany are taxable in Germany – the catalogue according to § 49 EStG is final.

It should therefore be noted that, as a rule, a residence leads to unlimited tax liability and pure sources of income or activities, without residence in the respective state, lead to limited tax liability. This principle and the aforementioned principles are not only pursued by Germany, but also by many other EU and third countries.

These principles are also applicable to corporations such as GmbH’s and AG’s. The starting points for corporations are, among other things, the registered office of the company and the place of management.

You can see that when cross-border or international activity, double taxation can arise relatively quickly if there are tax connecting points. According to national law, if the other state has an equal understanding of the principles, double taxation would arise. Only in a further examination step will the double taxation agreement be consulted.

In some cases, sources of income may not lead to a limited tax liability. According to German law, the limited tax liability must have an income type according to § 49 EStG. The facts listed therein are exhaustive. If the income is not included or does not fulfil any event, they do not lead to a limited tax liability.

Since then there is no limited tax liability, there would not be double taxation if the income were taxed elsewhere.

To best understand double taxation, we use three examples:

A thus has two tax residences and is therefore subject to unlimited tax in both states (Germany and France). There is a taxation of all income in both countries (double taxation).

B lives in Paris and holds shares in a German GmbH (headquartered in Germany). Deutsche GmbH pays its profit for the previous year as a dividend.

B is subject to unlimited taxation because of his residence in France, which is why the world income principle applies here. Therefore, the dividend is taxable in France. However, the dividend also triggers, since it is paid by a German GmbH, a limited tax liability in Germany (source country). This leads to double taxation of the dividend.

To avoid double taxation, states conclude double taxation agreements (DTAs) with each other. These international treaties (supranational law) take precedence over national law and determine the tax jurisdiction of income and profits. This means that, as shown in our examples, although double taxation actually takes place (in a first step), this is avoided by the DTA. The DTA allocates the income or profit to one of the two Contracting States, whereas the other Contracting State waives its right to tax. Since Germany has concluded its own DTA with each contracting party (for example Denmark, Austria, USA), different taxation regulations have also been agreed to avoid double taxation.

The contracting states have therefore each concluded their own DTA, which leads to their own agreements. However, the basis for the negotiations is usually the OECD Model Agreement (OECD-MA). Instead of designing a DTA “out of nothing”, the OECD Model Agreement is used as a draft. On this basis, individual articles and provisions can be amended in the negotiations of the States Parties. After the conclusion of the contract, the DTAs will be converted into national law by ratification, which finally makes them valid for tax purposes.

The OECD-MA and the DBA based on it only regulate the avoidance of double taxation of income and assets – this type of DBA is widespread. Less widespread, however, are DBA for inheritance tax and gift tax purposes.

Now that a DTA has allocated the income to one of the two contracting states, the question of the method for avoiding double taxation in the other state arises. In many cases, the exemption method applies, which means that the other contracting state (which has not been allocated the income) waives the taxation of the income and exempts it from taxation.

The other method, which is less widespread, is the credit method. In this method, both Contracting States tax the income, although the income was attributed to Contracting State A. However, Contracting State B shall count against its own tax the taxpayer has paid to Contracting State A for such income.

Double taxation usually requires a starting point, which is usually a cross-border activity. Connecting points can be pure sources of income, or else companies and branches. Since an international orientation of their business opens up new (economic) opportunities for many entrepreneurs, it is important to pay attention to tax points of reference and to recognize them. However, such international activities also offer new scope for tax arrangements in order to avoid harmful regulations and to benefit from tax advantages.